How Fiscal and Monetary Policies Affect the Forex Market

Gross Domestic Product and Inflation

Many of us would agree that we want to live in a country that is competitive and has a good standard of living compared to other countries around us. Many of us would also probably like the option to buy relatively cheap foreign products for our everyday use. Most economists would also agree that one of the primary international goals of macroeconomic policy is to maintain the position of the U.S. as one of the leaders in the world economy.

But how does one measure all of this? That is where the debate begins. Some believe a balance of trade deficit or surplus is the key measurement. Other economists might argue that we should look at the value of the exchange rate. This lesson will focus on the exchange rate and how fiscal and monetary policies can affect it and the prices we pay for goods every day.

Review of Basics

To review, an exchange rate is simply the rate at which one country’s currency can be traded or exchanged for another country’s currency. It determines how cheap or how expensive it is for you to buy goods, such as televisions, clothes, and tires for your car. A high exchange rate for the U.S. dollar makes foreign currencies cheaper, which lowers the price of imports. This means you can buy more electronics and other goods and services for every dollar you make!

A low exchange rate makes imports more expensive because your dollar won’t buy as much foreign currency. Although this means you will spend more of your paycheck on normal everyday items, on the flip side, it encourages exports, which can cause a balance of trade surplus and help the economy grow.

Now that we have recapped a few of the basics, let’s dive deeper into how fiscal and monetary policy affect the exchange rate.

Fiscal Policy Effects

Fiscal policy, which is the use of government spending or taxes to grow or slow down the economy, can affect the exchange rate in three different ways. It can affect exchange rates through income changes, price changes and interest rates. Let’s explore each now.

Income Changes

When the government lowers your taxes through fiscal policy, it puts more income in your pocket! This means more shopping and morning stops at the local coffee shop, usually resulting in overall increased demand for goods and services. This means more imports. You have more money; you want to spend it! The rise in imports results in U.S. citizens selling more dollars to buy foreign currencies to pay for those imported goods. This decreases the dollar exchange rate, ultimately leading to more expensive products in the future.

Price Changes

When the government wants to grow the economy, it is known as expansionary policy. To do this, the government can reduce taxes or spend more to stimulate the economy. When the government spends more or decides to cut your tax bill, this ultimately leads to increased demand, which pushes the overall price of goods and services higher.

As the prices of goods increases, this also makes exports of our goods to other countries more expensive and imports more attractive. This leads to higher demand for foreign currency to buy goods and lower demand for dollars to purchase U.S. goods. This lowers the exchange rate. Contractionary policy, which is characterized by a decrease in government spending or increases in taxes, has the opposite effect.

Monetary Policy Effects

Monetary policy, which is headed by the Federal Reserve and involves changing the money supply and credit availability to individuals, can also affect the exchange rates. Similar to fiscal policy, it can affect the exchange rates through three paths: income, prices and interest rates.

Income

Monetary policy acts in much the same way as fiscal policy in relation to income. When the money supply rises or credit gets easier (for example, your ability to get a loan), the income in your pocket increases. As our pocketbooks get bigger, we spend more money on imports. As we sell dollars to buy foreign currencies so we can pay for those exciting new goods, this decreases the dollar exchange rate. On the other hand, contractionary monetary policy, which leads to lower money supply or tighter credit, causes U.S. income to fail. This leads to fewer imports, less demand for foreign currency and a rising U.S. exchange rate.